The Savings Game: Health savings accounts, beneficiaries and tax liability

by Diane Graff | Watertown Daily Times

I have written previously about the tax advantages associated with health savings accounts. Contributions are tax-deductible regardless of income. Returns on contributions grow tax-deferred. As long as distributions are used for qualified medical expenses, they are untaxed. And if one makes contributions through tax-deferrals, wages subject to Social Security and Medicare taxes are reduced.

Another significant advantage of an HSA is that one is not required to withdraw either the contributions or the earnings at the end of each year. One can maintain the balances as long as they like without incurring federal income taxes. Some health insurance premiums and some long-term care premiums are considered qualified expenses. See IRS Publication 969 to determine what insurance premiums are covered.

In a recent publication of Ed Slott & Co., Ronald McKeown, CPA, CFP, who is associated with the Wealth Enhancement Group in Mankato, Minn., pointed out some of the issues related to beneficiaries of HSAs. Only surviving spouses named as beneficiaries are able to retain the tax advantages associated with these accounts. He pointed out that HSA assets are now more than $24 billion. Accordingly, it is important that owners of these accounts understand the pros and cons of different beneficiary options.

If one names a spouse as the beneficiary of the account, he or she can continue to take advantage of the tax advantages. If the surviving spouse is not old enough to be eligible for Medicare, then he/she can make additional deductible contributions to the account. The surviving spouse can pay any outstanding qualified expenses that one incurred during their lifetime without any income tax liability. The surviving spouse can also withdraw funds from the account to pay qualified medical expenses he/she incurs as well. Any withdrawals that are not related to qualified health expenses are taxable at ordinary income tax rates.

In addition, if a surviving spouse remarries, he/she can designate the new spouse as the named beneficiary and these tax advantages continue for the new beneficiary.

However, if one names a nonspouse as the beneficiary, then all assets in the plan must be distributed immediately, and they will be taxed at ordinary income tax rates of the beneficiary. The only exception is that any prior unpaid qualified health expenses of the deceased owner can be paid without tax consequences. So if one has a choice regarding whom to select as beneficiary of the HSA account, one should consider a party who is not in a high tax bracket.